Harry
Browne has experienced a renaissance of late, and a critical
examination of his "permanent portfolio" teachs a lot about the
nature of investing and investors.

First, some background. Harry, who died in 2006, was best
known as the libertarian candidate for president in 1996 and 2000.
However, he was also a financial advisor and radio commentator who began
writing and speaking about personal finance in the 1970s. Originally a
gold-bug newsletter writer, over the decades Harry’s thinking evolved
along with advances in the empirical literature. He gradually came to
embrace the gospel according to Fama, Bogle, and Malkiel so familiar to
readers of these pages: timing the market, selecting securities, listening
to gurus, and buying newsletters were mugs’ games. Talk about
critical self-examination!

The more he delved into and personally experienced
financial history, the more he became convinced of his—and anyone else’s—inability to predict
the future. His conclusion: one’s personal wealth was far too precious to
expose to the cruel mistresses of market timing and security
selection; buy widely diversified low-cost mutual funds, especially if
passively managed.

So far, so good. Harry then carried the logic of passive
investing one step further. He assumed that three different economic
scenarios threatened investors: inflation, deflation, and "tight money,"
the last of which he was a tad vague about, but best describes, I suppose,
the shock therapy that Paul Volcker applied to the economy in the early
1980s. He thus prescribed a mix of 25% each of Treasury bills, long bonds,
gold bullion, and stocks, reasoning that under any circumstance at least
one or two of these assets would save your bacon. (This is not that far
off from the asset allocation recommended by the Talmud: one-third each in
land, business interests, and "reserves," the latter of which, in those
days, meant silver.) If this seems a bit extreme today, realize that by
the late 1970s, Harry was looking for a method of diversifying away
from an all-precious-metals portfolio. Harry’s right-wing paranoid streak
also led him to suggest spiriting assets abroad in case Uncle Sam
decided to confiscate the nation’s nest eggs. Since I don’t have
the legal qualifications to judge the orange-jumpsuit risk inherent in
that aspect of his strategy, I won’t discuss it further.

From this point on, I’ll refer to his 25/25/25/25 mix as
the "theoretical permanent portfolio" (TPP), where stocks = CRSP universe,
gold = spot gold price, long bonds = 20-year government index, and T-bills
= 30-day U.S. Treasuries. There is, though, nothing theoretical about this
allocation; it’s eminently investable at minimum cost. The CRSP universe
is nearly identical to a total stock market fund, the bonds and bills can
be deployed individually as a "bar bell" or even more simply, if somewhat
clumsily, as a 30-year ladder, and gold can be purchased as coins or, if
you trust ETFs (I don’t), as GLD.

In many respects, this allocation is a thing of beauty.
Not only does it provide some protection against all but the most dire of
scenarios, but its correlation grid is one rarely seen in finance: four
non-derivative assets populated entirely by near-zeros:

Gold

Stocks

Long Bonds

T-Bills

Gold

1.00

Stocks

-0.16

1.00

Long Bonds

-0.20

0.05

1.00

T-Bills

0.02

0.05

0.11

1.00

For annual returns, 1964–2009.

How has the TPP done over the years? Not badly at all:
when rebalanced annually since 1964, it has returned 8.53% per year with a
standard deviation (SD) of 7.67%. For comparison, a 60/20/20 portfolio of
stocks, bills, and long bonds returned 8.83%, but with a much higher SD of
11.25%. How about the bad times? In 2008, the TPP lost only 1.31%, versus
a loss of 16.52% for the more conventional 60/20/20 portfolio. What about
inflation? During the nine years between 1973 and 1981, inflation ran at
an annualized 9.22%; the TPP returned 12.06% versus only 6.35% for the
conventional portfolio, which also had a higher SD to boot.

Of course, we can juggle the numbers in multiple ways.
Make 30% of the conventional stocks foreign (to make the conventional
portfolio 42/18/20/20) and its return rises to 7.47% between 1973 and
1981. Further, value and small stocks tend to protect against inflation,
since they do better than large growth stocks in such periods as they are
more highly leveraged, and their balance sheets benefit from the inflating
away of their liabilities. Below, I’ve plotted the return and SD of the
TPP versus that of the small- and value- heavy DFA balanced strategies for
the 1973–2009 period:

For a strategy that is stone-simple, does not require DFA
funds, and has lower execution costs, the TPP does not do half badly.
Realize, however, that it is a modest-return, low-risk portfolio and
won’t buy many yachts. As Harry pointed out on multiple occasions, you get
rich not by investing brilliantly, but rather by saving
and safeguarding conscientiously.

So what’s the catch? In a nutshell, Harry’s strategy is a
bit like communism: elegant in theory, but very difficult to execute
in practice (no small irony, given Harry’s politics). It so happens that
there’s a mutual fund that follows the TPP, the venerable Permanent
Portfolio (PRPFX). Between 1983 and 2009, it returned 6.62% at an SD of
8.16%, versus 7.77% with an SD of 5.85% for the real TPP. The fund's lower
return is easily explained by management fees, currently at 0.82%, but
well in excess of 1% for most of its history. The higher SD is explained
because the fund does not precisely follow TPP’s strategy; it currently
holds 31% stocks, heavily weighted towards the energy and REIT sectors,
versus 25% of the market portfolio for TPP. Consequently, it
did worse in 2008 than the TPP: –8.35% versus –1.31%.

Even so, in 2008 most investors would have been
happy with PRPFX’s single-digit loss, and this attracted a lot of
attention, as did the TPP.

PRPFX’s fund flows over the years serve as a
good proxy for investor interest in the TPP. The turbulence
surrounding the 1987 crash blessed the portfolio’s management,
and its assets peaked out at nearly $100M in late 1989, a respectable
size for that period. During the frothy 1990s stock market, however,
investors abandoned the fund in droves, and presumably the TPP strategy as
well. By late 2001, PRPFX languished at $52 million, a remarkable figure
considering that between those two dates the return of the
portfolio alone should have grown its assets by
71%, and total U.S. mutual fund assets had increased
approximately seven-fold.

Since the 2008 crisis, investors have piled back into
PRPFX with a vengeance, bloating its assets to over $6 billion.
As you might expect, you can drive a small pickup truck between the fund's
time-weighted returns (10.10% annualized for the 10-year period ending
7/31/10) and dollar-weighted returns (6.41%). Investment discussion
boards now fairly bulge with TPP threads. For example, the
typical topic runs a few dozen messages on the respected Vanguard Diehards
board; one Harry Browne sequence weighed in at nearly 3,500 posts.

And therein lies the real problem with the TPP: because
of its huge tracking error relative to more conventional portfolios, it
attracts assets and adherents during crises, then sheds them in
better times. There’s nothing wrong with Harry’s portfolio—nothing at
all—but there’s everything wrong with his followers, who seem, on
average, to chase performance the way dogs chase cars.

Investment success accrues not so much to the
brilliant as to the disciplined, and the nature of the chosen strategy
contributes mightily to this calculus. The very worst place an investor
can find herself is, in the words of Mark Kritzman, "wrong and alone";
this is a near certainty at some point given the TPP’s
huge tracking error relative to that of the overall market portfolio,
approximated by a 60/40 mix of stocks and bonds. Thus, it will be
nigh-impossible for even the most disciplined investors to adhere to
the TPP in the long run. (And lord knows, most investors are unable to
stick to even a 60/40 portfolio.)

Diversifying asset classes, as Harry Browne knew well,
can benefit a portfolio. The secret is deploying them before those
diversifying assets shoot the lights out. Harry certainly did so by
moving away from gold and into poorly performing stocks and bonds in the
late 1970s. Sadly, this is the opposite of what the legions of new TPP
adherents and PRPFX owners have been doing recently—effectively increasing
their allocations to red-hot long Treasuries and gold. Consider:
over the long sweep of financial history, the annual real return of long
bonds and gold have been 2% and 0%, respectively; over the decade
ending 2009, they were 5% and 11%.

Many investors currently have the Harry Browne portfolio.
The 1990s stampede of assets out of PRPFX and the more recent stampede
back in suggest that few will turn out to have the Harry
Browne right stuff.